Entrepreneurship offers numerous advantages, such as the exhilarating experience of building a business from scratch. However, many self-employed individuals are concerned the path to homeownership can present unique challenges compared to those with traditional employment since the nature of owning a business often leads to irregular income patterns and varied documentation. While that can be true in some cases, lenders will still be considering the same factors for a mortgage approval as any other type of borrower: your credit score, debt, assets, and income.
What Documents Do You Need To Provide?
Lenders need to ensure that a borrower can afford the loan they have applied for and will likely request the following documents from self-employed borrowers:
- Last two years of filed personal tax returns
- Last two years of filed business tax returns
- Year-to-date profit and loss (P&L) statement
- Evidence of your business existence
How Is Your Income Calculated?
Lenders will calculate your income by completing a cash-flow analysis from your last two years of tax returns and the income will be considered from various sources such as W-2, net business profits, K-1 earnings, and more. Let’s go over an example below:
Say your business earned $300,000 total in the last two years. If you had written off $180,000 in expenses in those two years, that would lower your net income down to $120,000. We would then divide your $120,000 net income by 24 months (two years) and qualify your monthly income at $5,000.
Please keep in mind that this is a very generalized example of how income is calculated and there are other factors that can impact qualification such as income stability, the location and nature of your business, the financial strength of your business, and the likelihood of you continuing to generate income in the future. We can also consider nonrecurring losses or expenses or depreciation, as a couple examples, to add back into income. In some cases, we only need to consider one-year of tax returns versus two-years.
Other Options For Self-Employed Borrowers
As a business owner, it’s understandable that you’d want to maximize your business deductions, which would result in a lower tax bill. However, showing low income on tax returns might not accurately represent the financial health or earning potential of the business. Homeseed recognized this issue and is also able to provide alternative solutions by offering unique loan programs such as Bank Statement loans, Profit and Loss (P&L) loans, and 1099 loans. These programs offer flexibility in income verification and cater specifically to self-employed individuals who may have non-traditional income documentation.
- Bank Statement Loans: Bank statement loans are designed for self-employed borrowers who may not have consistent or easily verifiable income. Instead of tax returns, these loans consider bank statements over a specified period (often 12 to 24 months) to assess the borrower’s income. Lenders review regular deposits as income, thereby offering an alternative method for evaluating a self-employed individual’s financial stability.
- Profit and Loss (P&L) Loans: P&L loans focus on the profitability of a business rather than personal income. These loans typically require the submission of profit and loss statements, business bank statements, and potentially other financial documents to assess the business’s overall health. This approach is beneficial for entrepreneurs who reinvest earnings into their business or pay themselves lower salaries for tax purposes. This loan type is also helpful when considering the timing of your purchase (for example, you have not filed current year’s taxes yet because the year is not complete, but you can provide a P&L statement to document current year-to-date income).
- 1099 Income Loan: Many freelancers, contractors, gig economy workers or other self-employed borrowers who file using W-9s cannot qualify for a mortgage under some Agency guidelines. Instead, these borrowers can use their 1099 earning statements in lieu of tax returns to qualify for a mortgage.
Tips for Self-Employed Borrowers
Self-employed borrowers face unique challenges in showcasing their income. This is especially important as we approach the end of the year and tax season approaches. Understanding the various methods of income calculation and different loan programs empowers individuals to prepare early for the mortgage process and purchasing a home. Seeking guidance from financial advisors or tax professionals will significantly aid in optimizing tax filings and accurately documenting income for loan applications as well.